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September 15, 2008

Wall Street Stunned

Merrill sold, Lehman bankrupt as credit woes come home to roost

Wall Street is not what it used to be, for good or ill. Culminating (at least for the moment) a months-long period of market volatility and uncertainty spawned by the credit/housing crisis and punctuated by a Federal government-engineered bailout of Bear Stearns at the end of March and a Federal takeover of Fannie Mae and Freddie Mac on Sep. 7, on Sep. 15 two marquee names in financial services ceased to exist.

Following a busy weekend in New York in which various government and corporate enterprises worked to shore up multiple corporate linchpins in the American financial system, Bank of America announced on Monday, Sep. 15 that it would acquire Merrill Lynch & Co. for $50 billion in stock, a deal that would create the largest brokerage firm in the world, with some 20,000 brokers (assuming they all have jobs once the transaction closes in the first quarter of 2009), and $2.5 trillion in client assets. The acquisition includes Merrill's 50% stake in BlackRock.

In a conference call with reporters from New York on Sep. 15, Bank of America Chairman and CEO Ken Lewis said the acquisition of Merrill Lynch is "the strategic deal of a lifetime." Lewis further said that the 16,000 Merrill brokers were the "crown jewel of the company," and that they "better get ready for a lot of referrals" from B of A's private client group.

Merrill Lynch Chairman and CEO John Thain answered a question about whether Merrill had approached any other suitors by saying, "I did not make any other phone calls." Under the deal, Bank of America would exchange 0.8595 shares of its common stock for each share of Merrill common, a price 1.8 times stated tangible book value. B of A said it expected to achieve $7 billion in pretax expense savings, and that the deal will be accretive to earnings by 2010.

At the press conference, Lewis said Bank of America would still be headquartered in Charlotte, North Carolina and that its investment banking operations would remain based in New York. However, it was not announced who will run the combined operation.

Lehman Files for Chapter 11

The other major casualty of the September weekend was Lehman Brothers Holdings, which after a desperate search aided by the government was not as fortunate in finding a suitor willing to assume its risks, leading the company to announce Sep. 15 that it will file for Chapter 11 bankruptcy protection, "in order to protect its assets and maximize value." The company said all its broker/dealers will continue to operate, as will its asset management arm, Neuberger Berman, though it said that it "exploring" the sale of both those operations. The SEC quickly announced Sep. 15 that retail customers of Lehman Brothers will be protected during the winding down, protection that includes "segregation of customer securities and cash" as well as SIPC insurance, and that SEC staff will oversee the "orderly transfer of customer assets to one or more SIPC-insured brokerage firms."

Meanwhile, the Federal Reserve had announced on Sep. 14 that it will accept additional, broader types of collateral in its Primary Dealer Credit Facility (PDCF) Term Securities Lending Facility (TSLF) programs, and is quadrupling the number of Schedule 2 TSLF auctions--to twice a week from once every two weeks.

A Change in the Model?

What will this mean for the shrinking number of Wall Street brokerage firms? Jefferson Harralson, a research analyst who covers banks at Keefe, Bruyette & Woods, believes the broker/dealer model "is going towards where a large balance sheet and core funding is crucial; we've seen that, now, twice. We're the only country in the world that has the broker/dealer separate from the larger bank. The volatility we're experiencing is proving to be too much for the broker/dealer model--at least in two instances. These large banks [that] have been very poorly positioned to compete before are now going to have an opportunity to compete better."

So will there be more acquisitions for Bank of America? Harralson argues that "after buying Countrywide and now following up so quickly with the Merrill Lynch deal, [Bank of America] will retrench now for a period of time, they will make sure that their capital levels are adequate, make sure that they integrate Countrywide and Merrill Lynch the best they can, but I don't see any more deals coming out of them for some time." So then, are there other banks that might be in a position to do more deals? Harralson demurs, "Very, very few. Most banks have their own issues with credit and most banks are relatively thin on capital. You have a JPMorgan out there that's positioned relatively well but it has already bought Bear Stearns. Most banks will look at deals where they might get a stressed price in their favor, but most banks are looking after their own problems right now."

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